Firstly, to have a good understanding of Dividend declaration date, Ex-Date & Record date, have a look at this post.
‘Dividend Stripping’ refers to buying stocks or units within 3 months before and selling it within 3 months (9 months in case of units) after the Record date. Price of the share decreases on the ex-date. Investors can take advantage of getting tax free dividend by investing in shares for a short term and also book short term capital loss by selling the shares after record date. This could then be used to set off the short term and long term capital gains made during the year. To curb this, Income Tax Act 1961 had introduced Section 94(7) from Assessment Year 2002-2003 of which many retail investors are not aware off.
Section 94(7) of IT Act mentions 3 conditions that should be satisfied for dividend stripping:
- Shares/units are acquired within a period of 3 months prior to the Record date of dividend;
- Shares are sold within a period of 3 month or units transferred within a period of 9 months after the dividend record date;
- The dividend received on such securities received or receivable is exempt from tax.
If all the above conditions are satisfied, Section 94(7) will apply and the short term losses is allowed to be set off only if it exceeds the exempted dividend income.
To show it as an example:
Mr. A purchases 100 shares of a company X Ltd. @ Rs 60/share on 15th April. X Ltd. declares dividend of Rs 5 per share and say that the record date is 30th May. Mr. A sold his shares in X Ltd. on 2nd August for Rs 48/share. He would receive Rs 500 as tax free income as dividend. He incurred short term capital loss of Rs 1200 (6000-4800). As per Section 94(7), the set off that can be utilised is only Rs 700 (1200-500).
Similarly, Bonus stripping falls under Section 94(8) of the IT Act. This is applicable on bonus units allotted by open as well as closed ended mutual funds. Bonus units means additional units allotted without any payment based on holding of original units. Generally, NAV of the MF units would fall after record date of bonus units. If any losses arise to a person on purchase and sale of original units, it shall be ignored from taxable income and shall not be allowed for set off if the following conditions are satisfied;
- An investor acquires the units within a period of 3 months prior to the record date
- Bonus units are allotted on the basis of holding of original units on record date
- The investor sells all or any of the original units within a period of 9 months after such record date
- He continues to hold all (or any) of the bonus units.
Section 94(8) applies only to bonus units issued by mutual funds and not to bonus shares issued.
If an investor thinks that a company has declared attractive dividend and that this exempt income would be higher than the loss incurred at the time of sale, it is a good strategy to buy.